Payday loans vs. installment loans: One is a much better option
Key takeaways
- Payday loans provide quick cash but have high interest rates and fees, making them risky.
- Installment loans offer larger amounts with lower interest rates and fixed monthly payments, making them more manageable.
- If you can't qualify for an installment loan, consider payday loan alternatives.
When an unexpected expense throws your budget off balance and you need cash fast, payday loans and installment loans may seem like quick fixes. However, payday loans are almost always a bad idea.
You should know the differences between these types of personal loans and which will be better for your finances before making any decisions.
Payday loans vs. installment loans
Payday and installment loans are short-term solutions when you need cash right away. The main differences are the ease of being approved, the amount you can borrow and how long you’re given to repay the loan (plus fees and interest).
Payday loans are typically smaller, often capped at $500. Installment loans can offer higher initial balances. Payday loans must usually be repaid in one lump sum payment on your next payday — often within 10 to 14 days of receiving the loan proceeds. Installment loans are generally paid off over several months or years.
While any loan has some risk, generally, installment loans are far less risky than payday loans.
| Payday loans | Installment loans | |
|---|---|---|
| Collateral requirement | Unsecured (no collateral required) | Typically unsecured, though some lenders offer loans secured by collateral |
| Loan amount | Typically $500 or less | Up to $100,000 |
| Funding timeline | Same day to one business day | Typically, same day to three business days |
| Repayment terms | One lump sum on your next payday (or within 14 days) | Paid over several months or years |
| Interest and fees | Flat fee of $10 to $30 per $100 borrowed; varies by state regulations | Typically much lower than payday loans but varies by credit score and lender |
| Application process | Quick, minimal requirements | More thorough credit check required |
| Impact on credit | No impact if repaid on time, but defaults can lower credit score | Can improve credit if repaid on time, defaults can harm credit score |
How do payday and short-term loans work?
Payday loans are short-term, high-interest loans designed to provide quick cash to borrowers in need. They’re typically used as a lifeline for people facing urgent financial situations who may not have access to traditional credit options.
However, due to their high rates and tendency to trap people in debt cycles, these loans are effectively or explicitly illegal in about half of U.S. states.
- Applying: Most payday loans have a simple application process with few requirements. Borrowers generally need to provide proof of identity, show they have a stable income and provide their checking account information.
- Approval: Loan approvals often occur in just a few minutes. Funds are usually delivered on the same day or within 24 hours.
- Amounts: The loan amount is typically capped at $500 or less, depending on state regulations.
- Repayment: Payday loan repayment terms are short and strict. Borrowers must repay the loan amount and fees by their next payday, which is typically within 10 to 14 days. This is often done through a postdated check or authorization for an automatic withdrawal from the borrower’s checking account.
If you cannot repay the loan, the lender may suggest that you “roll it over” by getting a second payday loan big enough to cover both the original amount and its fees. That option often leads to a cycle of ever-growing debt.
While the speed and ease of obtaining a payday loan can be appealing, the high interest rates and short repayment period can lead to financial strain.
Pros and cons of payday loans
Before you commit to a payday loan, weigh the potential benefits against the drawbacks. Nearly 12 million Americans take out payday loans every year. However, these loans can be devastating to your finances.
Pros
- Payday loans offer quick access to cash: Funds are often available within the same day. That makes them helpful in emergencies.
- It’s easy to get approved for a payday loan: Minimal credit requirements make payday loans accessible for individuals with poor credit or no credit history.
- The application process is quick and simple: It typically requires only basic information, such as proof of identity and income.
Cons
- Payday loans are expensive: They often have steep fees, making them an extremely expensive borrowing option. Their flat fees may translate to an annual percentage rate (APR) of 600 percent or more.
- Payday loans can trap you into a debt cycle: People constantly strapped for cash can become reliant on payday loans. Original loans often roll over into new, larger loans with the same fees and high interest rates. That makes the loans harder to pay back.
- The lender may have direct access to your checking account: Lenders often require authorization to withdraw payments directly from your bank account. You may be charged overdraft fees if there isn’t enough money in your account.
- Payday loans offer limited loan amounts. The amount you can borrow is often capped at $500 or less, which may not be enough for larger needs.
- Payday loans can be predatory: Payday lenders don’t review credit scores, and they often give loans to people who can’t afford to repay them. The lenders might only care about collecting on the high fees and interest rates.
How do installment loans work?
Installment loans offer a more structured and often more affordable borrowing option. These loans offer a larger sum of money and predictable monthly payments over a longer period.
- Applying: The application process for an installment loan is more thorough than that of a payday loan. You must provide more information, including proof of identity and stable income, and undergo a credit check. This information lets lenders assess your ability to repay the loan.
- Approval: If you apply online, approval typically takes only a few minutes or hours. Funding typically happens within one to three business days, though some lenders offer same-day funding and others warn it could take up to two weeks.
- Amounts: Loan amounts for installment loans can range from a few hundred dollars to $100,000, depending on the lender and the borrower’s creditworthiness.
- Repayment: Terms for installment loans are more borrower-friendly than payday loans. Borrowers repay the loan in fixed monthly payments over several months or years, depending on the loan agreement. The interest rates on installment loans are also generally lower than on payday loans.
This structured repayment plan makes it easier for borrowers to budget and manage their finances while repaying the loan.
Overall, installment loans provide a more sustainable solution than payday loans.
Pros and cons of installment loans
While installment loans are better than payday loans, all types of borrowing come with risk. Here’s a look at the pros and cons of installment loans.
Pros
- Installment loans have lower interest rates: Generally, installment loans have significantly lower APRs compared to payday loans, making them more affordable.
- The payments are easier to manage: The extended repayment period allows for smaller, more manageable payments spread over several months or years. Fixed monthly payments also make it easier to budget.
- On-time payments can build your credit: Most installment loans are reported to the major credit bureaus, so on-time payments positively impact your credit score.
- You can use an installment loan for many purposes: Funds from installment loans can be used for debt consolidation, major purchases, unexpected expenses and more.
Cons
- Potential fees: Origination, late and insufficient funds fees can add to the overall cost of the loan. It’s important to compare lenders to find the lowest-cost option.
- Long-term commitment: Monthly payments can stretch out over several years, requiring long-term financial planning and discipline.
- Risk of additional debt: A large loan increases your overall debt, putting your finances at risk if your circumstances change and you cannot make payments.
- Credit check required: A credit check is part of the application process. People with poor credit scores might not qualify.
- Possible negative impact on credit: Missing payments or defaulting on the loan can negatively impact your credit score and lead to collection actions.
Other alternatives to payday loans
If you’re not able to qualify for a traditional installment loan due to bad credit, you may consider working with a reputable credit repair company to raise your score, rather than taking a payday loan.
If you need emergency cash fast and can’t wait, it may make sense to explore some other alternatives to payday loans:
- Payday alternative loans (PAL). Credit unions sometimes have payday alternative loans. These loans are for small amounts, usually below $1,000, and are repaid over a few months.
- Ask your employer for an advance. Your employer may be willing to offer you an advance on your paycheck.
- Negotiate a payment plan with creditors. Contact your creditors to explain your financial situation. They might have hardship programs or payment plans that would help.
- Ask family or friends. Asking a family member or friend for a short-term loan can help you avoid high interest rates and fees. Be sure to create a contract before accepting the money, so everyone is protected.
The bottom line
If you’re experiencing financial hardship or need emergency funding, a payday loan is not your only option. Installment loans offer a more flexible repayment schedule and lower borrowing costs.
A short-term loan may seem like a solution to an immediate need for cash. However, getting a loan could hurt your long-term finances if you aren’t careful. Research your options before you make any decisions.
Frequently asked questions
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Each lender sets its own minimum approval requirements for installment loans, but many major lenders require a credit score in the mid-600s or higher. Some lenders specifically offer personal loans for fair or poor credit and will loan to borrowers with scores between 300 and 669.
The higher your score, the more favorable your terms and rates. -
Yes, in many cases, installment loans allow you to pay off the balance early without a penalty. Paying off your loan early can help you pay less interest over the lifetime of the loan and become debt-free sooner. However, it’s important to check with your lender to confirm there are no prepayment penalties.
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If you can’t repay a payday loan, the lender may attempt to withdraw funds from your bank account, potentially causing overdraft fees. Failure to repay can lead to additional fees and interest, increasing your debt.
The lender may also send your account to collections, which can damage your credit score and result in collection actions such as wage garnishment.
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